Today, year-on-year U.S. inflation rose to 5% for May from 4.2% in April. The highest level in over a decade. While the spikes in pricing for used cars and airfares have grabbed headlines, the move is broad-based. If sustained, this elevated inflation rate will impact your savings, even if asset prices don’t move. Here’s why.
It’s Not Just About Airfares and Used Cars
You may have heard that both airfares and used cars are up almost 30% year-over-year. That matters. Yet, their weight in determining inflation is small. Even if prices for these two categories were completely flat, inflation would still be running at around 4%. As such, it’s hard to isolate just a couple of items and say that they are driving the high inflation number. A lot of prices are rising currently from car insurance, to energy to other commodities. Rising inflation is not currently being driven by a price spike in a single category.
However, if you’re looking for the big costs that can really move the inflation number then its food and housing. Those two categories make up roughly half of spending and so about half of the inflation number. Currently those costs are rising at around 2% a year, so at a slower rate than other goods and services. Were those costs to move materially higher or lower, then the inflation rate would likely move too.
If inflation is 0% then earning 5% on your portfolio gives you, predictably, a 5% real return. Economists use the term “real” to describe the impact of your return after inflation. Now, with inflation running at 5% you’d want a 10% return on your money to preserve your spending power at the same level.
It may not be immediately obvious that inflation is hurting your investment returns, but it very likely is. That’s because at some point you’re going to want to spend the money you’ve saves and now it won’t go as far, should inflation remain elevated.
Even Small Differences In Inflation Do Matter
Also, small differences in inflation rates can really matter if sustained. At 2% inflation the value of a dollar halves in about 36 years, with 5% inflation the value of a dollar halves in 15 years. Just a small increase in the inflation rate can erode the value of your money much faster.
Thus far, aside from moves in the bond market earlier in the year, the markets haven’t shown much of a strong response to inflation remaining at high valuations. If anything, stocks have focused on the positives of surging demand, rather than the negatives of rising inflation. This is likely because the markets view current elevated inflation as temporary and don’t believe the Fed will react in raising rates. If either of those factors change, then the markets will likely take note.